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Rental Investments: Sane or a Pain? by Douglas Carlsen, DDS

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Interest rates for housing are at historically low rates and housing prices are now beginning to rise in earnest. Investing in rental real estate might seem to be a good choice for a solid stream of income.

Watch out, says Christopher J. Mayer, professor of real estate, finance and economics at Columbia Business School. "There is a lot of idiosyncratic risk associated with rental income. That is the word that economists use for when a lot of things can go wrong, even if on average they don't go wrong very often."1

Risk #1: Inflated Value

According to Tara Siegel Bernard, the Blackstone Group and other Wall Street investors are gobbling so many properties in one fell swoop, especially in Sun Belt areas, that a high percentage of properties are selling at artificially inflated values.

Before you invest, Susan Kaplan, Certified Financial Planner in Newton, Massachusetts, says, "You must get data on vacancy days of comparable properties, length of time in tenant turnovers, rental rates in your community and general demand."2

Risk #2: Mortgage Risk

Taking out a mortgage to finance a rental property increases your risk, even if you have a cushion between all payments for mortgage, property taxes, insurance, maintenance and upgrades, vacancy reserve and property management.

Professor Mayer states that you are borrowing to expand the size of your investment portfolio. "If stuff [housing] goes down in value, that leaves you much more exposed. Borrowing money to earn a higher return involves risk."3

In today's lending climate, you will probably not be able to finance more than 65 percent of the rental and "your mortgage rate might be two percentage points higher than the average for owner-occupied homes," according to Greg McBride of Bankrate.com.4

Any investment that involves leveraged debt requires extensive study. Few doctors ever take that time and many lose vast amounts of money in the process.

Risk #3: Prolonged Vacancy

A long-term vacancy, due to a broken sewer line or a damaged roof will harm your investment, as will a tenant out of a job. Yet more infrequent events occur more often now due to climate change.

Hurricane Sandy is a recent example of prolonged absence of rental payments for many owners who are fighting insurance companies for their financial lives. Not only have they lost rental income, but have impaired home principle due to beach and tree damage even after full repair to their homes. Other severe storm areas of the 2011 massive tornado outbreaks in Joplin, Missouri, and Birmingham, Alabama, will take decades to restore the foliage and subsequent value of homes lost.

Kenneth Eaton, financial planner in Overland Park, Kansas, says, "You need a sizable reserve fund set aside to pay for expenses, whether it's to cover the mortgage for a stretch of when the property is sitting vacant or to make repairs, which novice landlords tend to underestimate."5

Risk #4: Lack of Portfolio Diversity and Liquidity

Are you diversified enough to afford a rental in your portfolio? Some doctors have well more than 50 percent of their savings in rentals. Most financial planners do not recommend real estate investment that totals more than 20 percent of one's total portfolio.

Note also that liquidity is low with any real estate investment other than traded funds such as REITs. You can't sell real estate overnight.

Two other areas to consider before purchase are:

Management: If you outsource to a property manager, you'll pay about 10 percent of the rental amount.6 If you don't, you'll need to screen tenants, fix the broken furnace, repair fences and the roof and run credit checks. In other words, you'll need to live close-by. Be sure to buy and read Janet Portman's Every Landlord's Legal Guide (Nolo, 2010) if you plan to manage on your own.

Tax Implications: Income from rentals is taxed at ordinary income rates. You may depreciate the structure, yet not the underlying land, including improvements, closing costs and appliances over a 27.5-year period. But the depreciation benefit disappears for couples with adjusted gross income over $150,000. Losses you can't deduct today may be deducted upon disposal of the property.7

If you plan to give the property to heirs upon your death, they will inherit the property at current market and not have to pay taxes on any gains.

Worksheet for Rental Return on Investment

Kathleen Kramer and Chris Clothier estimate the rate of return you might get before any price appreciation. The worksheet is revised from Money Magazine.8

Kramer and Clothier state that professional rental investors seek a minimum 10 percent return on investment before price appreciation. So should you. In other words, do not rely on price appreciation alone as home prices over time grow little more than inflation.

Initial Outlay

Closing Costs (National Avg. $3,754 in 2013) + Rehab Costs + Purchase Price - Amount Financed = Initial Outlay

Note: For rehab costs, get a contractor's opinion. If there is electrical or structural damage, walk away, according to Chris Clothier.

Net Annual Cash Flow

Annual Rent - Annual Mortgage Interest - Annual Taxes and Insurance (often 1.5 percent of total rental value) - Annual Maintenance (one percent of rental total value for every decade old) - Property Manager (10 percent of annual rent) - Vacancy Reserve (10 percent of annual rent) = Net Annual Cash Flow

Note: Get rental data from a broker before purchase! Compare your property's condition to listings on Pad Mapper.

Net Cash Flow/Initial Outlay x 100 = Return on Investment

As indicated, Kramer and Clothier recommend a minimum 10 percent return on investment.

Example: A doctor wishes to purchase a $200,000 rental property that is 20 years old. He has had a licensed contractor inspect the home and has found no major structural or electrical problems. The contractor indicates the home will need minor inside and outside painting and landscape repair of $4,000 total.

The doctor finds that similar rentals in the area garner $1,500 per month.

His mortgage rate is 3.6 percent (low because of his 50 percent down payment) with payments of $455 per month of which $295 (annually $3,540) is interest in the first year. His property taxes and insurance will be $3,000 per year, estimated yearly maintenance for the 20-year-old home will be $4,000, the property management will cost $1,800 per year, and he will have a vacancy reserve total of $1,800 per year.

Initial Outlay Calculation

Closing costs for the home are $3,000, the rehab will be $4,000, the purchase price is $200,000 and the amount financed is 50 percent or $100,000. Therefore the Initial Outlay is $107,000.

Net Annual Cash Flow: Using the previous numbers, we find the net annual cash flow is $3,860.

$3,860/$107,000 gives a 3.6 percent annual return before any price increases.

Is 3.6 percent return enough to counter possible inflated value risk, leverage and liquidity risk, and unexpected property damage risk? In this case, the doctor decided no.

For an alternative method to evaluate a rental, William Jordan, who heads a wealth management firm in Laguna Hills, California, says, "As a convenient, easy formula, you can expect positive cash flow from an investment property if the monthly rent is at least one percent of the purchase price."9

For the above rental, a one percent per month rental rate of $2,000 per month, recommended by Mr. Jordan, would generate a return on investment of $9,860 using the worksheet, or a 9.2 percent return. That would be much more desirable.

References
  1. Tara Siegel Bernard, Rental Investment May Seem Safer Than It Really Is, The New York Times, March 29, 2013.
  2. "Is rental property right for you," Consumer Reports Money Adviser, September 2011, page 12.
  3. Tara Siegel Bernard article.
  4. "Is rental property right for you," page 12.
  5. Tara Siegel Bernard article.
  6. Kathleen Kramer and Chris Clothier, Worksheet: Should You Invest in a Rental, Money Magazine Real Estate Issue, January 2013, page 136.
  7. "How to deduct depreciation," Consumer Reports Money Adviser, September 2011, page 13.
  8. Kathleen Kramer and Chris Clothier.
  9. "Is rental property right for you," page 13.
Author's Bio
Dr. Douglas Carlsen has delivered independent financial education to dentists since retiring from his practice in 2004 at age 53. For Dentists' Financial Newsletter, visit www.golichcarlsen.com and find the "newsletter" button at the bottom of the home page.

Additional Carlsen Dentaltown articles are at: www.dentaltown.com. Search "Carlsen." Videos available at: www.youtube.com/user/DrDougCarlsen. Contact Dr. Carlsen at drcarlsen@gmail.com or 760-535-1621.
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